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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the quarterly period ended October 31, 1998
or
[ ] Transition report under Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the transition period from _____ to _____
Commission file number: 0-24346
VIDEO UPDATE, INC.
------------------------------------------------------
(Exact Name of Registrant as Specified in its Charter)
Delaware 41-1461110
------------------------------- ----------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
3100 World Trade Center
30 East 7th Street
St. Paul, Minnesota 55101
-------------------------
(Address of Principal Executive Offices)
(Zip Code)
(651) 312-2222
----------------------------------------------------
(Registrant's Telephone Number, Including Area Code)
Not Applicable
---------------------------------------------------------------
(Former name, former address and former fiscal year, if changed
since last report)
Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
The number of shares of Class A Common Stock, $.01 par value, outstanding
at December 14, 1998 is 29,278,518.
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VIDEO UPDATE, INC.
INDEX
PART I - FINANCIAL INFORMATION PAGE NO.
- ------------------------------ -------
Item 1. Financial Statements
Consolidated Balance Sheets - April 30, 1998 and October 31, 1998 3
Consolidated Statements of Operations - Three Months and Six
Months Ended October 31, 1997 and October 31, 1998 4
Consolidated Statements of Cash Flows - Six Months Ended
October 31, 1997 and October 31, 1998 5
Notes to Consolidated Financial Statements - October 31, 1998 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 7
PART II - OTHER INFORMATION
- ---------------------------
Item 1. Legal Proceedings 14
Item 6. Exhibits and Reports on Form 8-K 15
SIGNATURES 15
- ----------
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
VIDEO UPDATE, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)
ASSETS
April 30, October 31,
1998 1998
--------- -----------
(Unaudited)
Cash and cash equivalents $ 1,433 $ 830
Accounts receivable 4,737 4,398
Inventory 12,449 15,949
Videocassette rental inventory -- net 94,452 94,308
Property and equipment -- net 69,720 71,210
Prepaid expenses 4,162 4,854
Income taxes receivable 2,430 307
Deferred income taxes 2,592 2,636
Goodwill and other intangibles -- net 85,360 83,640
Other assets 1,096 1,202
========= ========
Total assets $ 278,431 $279,334
========= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Notes payable $ 104,488 $116,283
Accounts payable 39,045 49,765
Accrued expenses 12,841 12,073
Accrued rent 5,073 6,387
Accrued compensation 7,685 7,063
Commitments and contingencies
Stockholders' equity:
Preferred Stock, par value $.01 per share:
Authorized shares -- 5,000,000
Issued shares -- none -- --
Class A Common Stock, par value $.01 per share:
Authorized shares -- 60,000,000
Issued and outstanding shares -- 29,278,518 293 293
at April 30,1998 and at October 31, 1998
Additional paid-in capital 117,641 116,645
Retained deficit (7,674) (26,781)
Foreign currency translation (961) (2,394)
--------- --------
Total stockholders' equity 109,299 87,763
--------- --------
Total liabilities and stockholders' equity $ 278,431 $279,334
========= ========
See accompanying notes.
Note: The balance sheet at April 30, 1998 has been derived from the audited
financial statements at that date but does not include all the information and
footnotes required by generally accepted accounting principles for complete
financial statements.
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VIDEO UPDATE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(In thousands, except per share amounts)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
October 31, October 31,
1997 1998 1997 1998
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Revenues:
Rental revenue $ 29,152 $ 53,359 $ 56,964 $ 108,655
Service fees 193 285 343 541
Product sales 3,786 8,540 6,630 14,681
--------- --------- --------- ---------
33,131 62,184 63,937 123,877
Costs and expenses:
Store operating expenses 27,973 58,132 53,372 113,065
Selling, general and administrative 2,949 5,188 5,623 11,107
Cost of product sales 2,362 6,456 3,852 10,099
Amortization of intangibles 720 1,929 1,240 2,907
--------- --------- --------- ---------
34,004 71,705 64,087 137,178
--------- --------- --------- ---------
Operating loss (873) (9,521) (150) (13,301)
Interest expense (670) (3,134) (1,176) (5,987)
Other income 74 26 180 181
--------- --------- --------- ---------
(596) (3,108) (996) (5,806)
--------- --------- --------- ---------
Loss before income taxes (1,469) (12,629) (1,146) (19,107)
Income tax benefit (462) -- (249) --
========= ========= ========= =========
Net loss $ (1,007) $ (12,629) $ (897) $ (19,107)
========= ========= ========= =========
Net loss per share-basic and diluted $ (0.05) $ (0.43) $ (0.05) $ (0.65)
========= ========= ========= =========
</TABLE>
See accompanying notes.
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VIDEO UPDATE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(In thousands)
<TABLE>
<CAPTION>
Six Months Ended October 31,
1997 1998
-------- --------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss $ (897) $(19,107)
Adjustments to reconcile net loss to net
cash provided by operating activities:
Depreciation and amortization 19,670 43,429
Accrued rent 1,212 1,314
Deferred income taxes 694 --
Loss on disposal of property and equipment -- 46
Changes in operating assets and liabilities, net
of acquisitions of
businesses:
Accounts receivable 179 339
Inventory (1,801) (3,500)
Income taxes (2,598) 2,079
Other assets (1,414) (525)
Accounts payable 9,516 10,240
Other liabilities 9 (1,064)
-------- --------
Net cash provided by operating activities 24,570 33,251
INVESTING ACTIVITIES
Purchase of videocassette rental inventory (26,799) (35,753)
Purchase of property and equipment (11,343) (8,035)
Investment in businesses, net of cash acquired (610) (169)
Notes receivable from officers (160) --
Payments on notes receivable 43 --
-------- --------
Net cash used in investing activities (38,869) (43,957)
FINANCING ACTIVITIES
Proceeds from notes payable 14,000 23,040
Payments on notes payable (2,029) (12,937)
-------- --------
Net cash provided by financing activities 11,971 10,103
-------- --------
Decrease in cash and cash equivalents (2,328) (603)
Cash and cash equivalents at beginning of the period 2,424 1,433
======== ========
Cash and cash equivalents at end of the period $ 96 $ 830
======== ========
</TABLE>
See accompanying notes.
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VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
OCTOBER 31, 1998
(Unaudited)
1. GENERAL
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the six months ended October 31, 1998 are
not necessarily indicative of the results that may be expected for the nine
months ending January 31, 1999, (in June 1998, the Company's Board of Directors
approved a resolution changing the Company's fiscal year-end from April 30 to
January 31, effective January 31, 1999). For further information, refer to the
consolidated financial statements and footnotes thereto included in the
Company's annual report on Form 10-K for the year ended April 30, 1998.
Reclassification
Certain prior year items have been reclassified to conform with the fiscal
1999 presentation.
2. EARNINGS PER SHARE
In 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, Earnings per Share. Statement 128
replaced the previously reported primary and fully diluted earnings per share
with basic and diluted earnings per share. Unlike primary earnings per share,
basic earnings per share excluded any dilutive effect of options, warrants and
convertible securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. All earnings per share
amounts for all periods have been presented, and when necessary, restated to
conform to the Statement 128 requirements.
The following table is a reconciliation of the basic and diluted earnings
per share computation:
<TABLE>
<CAPTION>
Three Months Six Months
Ended October 31, Ended October 31,
---------------------- -------------------
1997 1998 1997 1998
-------- -------- ------ --------
(In thousands, except per share amounts)
<S> <C> <C> <C> <C>
Numerator:
- ----------
Numerator for basic and diluted earnings per share--
net loss available to common stockholders $ (1,007) $(12,629) $ (897) $(19,107)
======== ======== ====== ========
Denominator:
- ------------
Denominator for basic earnings per share--weighted-average shares
Class A common shares 18,105 29,279 18,105 29,279
Class B common shares 700 -- 700 --
-------- -------- ------ --------
Denominator for basis earnings per share 18,805 29,279 18,805 29,279
Effect of dilutive securities:
Contingent stock acquisition 177 -- 177 --
-------- -------- ------ --------
Dilutive potential common shares 177 -- 177 --
-------- -------- ------ --------
Denominator for diluted earnings per share--
adjusted weighted-average shares and assumed conversions 18,982 29,279 18,982 29,279
======== ======== ====== ========
Basic net loss per share $ (0.05) $ (0.43) $(0.05) $ (0.65)
======== ======== ====== ========
Diluted net loss per share $ (0.05) $ (0.43) $(0.05) $ (0.65)
======== ======== ====== ========
</TABLE>
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3. COMPREHENSIVE INCOME
As of May 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 130, Reporting Comprehensive Income (Statement 130). Statement 130
establishes new rules for the reporting and display of comprehensive income and
its components; however, the adoption of the Statement had no impact on the
Company's net loss or stockholders' equity. Statement 130 requires unrealized
gains or losses on the Company's foreign currency translation adjustments, which
prior to adoption were reported separately in stockholders' equity to be
included in other comprehensive income. Prior years' financial statements have
been reclassified to conform to the requirements of Statement 130. During the
three months ended October 31, 1997 and 1998, total comprehensive loss amounted
to $ (1,446,000) and $ (13,080,000), respectively; and during the six months
ended October 31, 1997 and 1998, total comprehensive loss amounted to $
(1,086,000) and $ (20,540,000), respectively.
4. INCOME TAX EXPENSE
The Company has estimated that its effective tax rate for fiscal year 1999
will be 0%. The Company has therefore used this rate in providing for income
taxes in the current quarter and six months ended October 31, 1998. The Company
will continue to evaluate and estimate its effective tax rate at the end of each
interim period during fiscal 1999.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of the financial condition and results of
operations should be read in conjunction with the Company's unaudited
consolidated financial statements and notes thereto appearing elsewhere herein.
OVERVIEW
The Company franchised its first store in January 1983 and opened its first
Company-owned store in September 1989. By July 1994, when the Company completed
its initial public offering, the Company had grown to 15 Company-owned stores
and 30 franchised stores. Subsequently, the Company substantially accelerated
its growth and as of October 31, 1998 operated 667 Company-owned stores in 33
states and five provinces in Canada, and had 72 franchised stores predominantly
in the United States. The majority of the Company's stores located in the United
States are superstores. Superstores are video specialty stores that carry more
than 7,500 rental units.
The Company generates revenues primarily from the rental of videocassettes
and video games, from service fees from its franchisees and from the sale of
products. As reflected in the chart below, rental revenue at Video Update stores
has accounted for the substantial majority of the Company's revenues. The
Company expects that this trend will continue.
Three Months Ended Six Months Ended
October 31, October 31,
------------------- -------------------
1997 1998 1997 1998
-------- -------- -------- --------
(In thousands) (In thousands)
Rental revenue $ 29,152 $ 53,359 $ 56,964 $108,655
Service fees 193 285 343 541
Product sales 3,786 8,540 6,630 14,681
======== ======== ======== ========
Total Revenues $ 33,131 $ 62,184 $ 63,937 $123,877
======== ======== ======== ========
Overall revenues, including same store sales, did not meet management
expectations for the first half of fiscal 1999, due in significant part to
certain factors, including: (i) Moovies locations not performing to management's
expectations for the period; and, (ii) the recent direct studio revenue sharing
arrangements obtained by some of the Company's largest competitors, including
the Blockbuster Entertainment division of Viacom, Inc. and Hollywood
Entertainment Corporation.
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Management is continuing several actions intended to enhance prospects for
profitable revenue growth for fiscal 1999. The Company successfully converted
all Moovies stores by November 30, 1998. During the first half of fiscal 1999,
the Company closed 25 under performing stores and performed significant
conversions on five other stores. As of November 30, 1998 the Company had
obtained four direct revenue sharing arrangements with major motion picture
studios and is pursuing additional direct revenue sharing arrangements with
other studios.
OPERATING RESULTS
The table below sets forth the percentage of revenues represented by
certain items included in the Company's statement of operations for the periods
indicated.
Six Months Ended
October 31,
----------------
1997 1998
----- ------
Revenues:
Rental revenue 89.1% 87.7%
Service fees 0.5 0.4
Product sales 10.4 11.9
----- -----
Total revenues 100.0 100.0
Costs and expenses:
Store operating expenses 83.5 91.3
Selling, general and administrative 8.8 8.9
Cost of product sales 6.0 8.1
Amortization of intangibles 1.9 2.4
----- -----
Total cost and expenses 100.2 110.7
----- -----
Operating loss (0.2) (10.7)
Other income (expense):
Interest expense (1.9) (4.8)
Other income 0.3 0.1
----- -----
Total other income (expense) (1.6) (4.7)
----- -----
Loss before income taxes (1.8) (15.4)
Income tax benefit (0.4) --
----- -----
Net loss (1.4)% (15.4)%
===== =====
SIX MONTHS ENDED OCTOBER 31, 1998 COMPARED TO SIX MONTHS ENDED OCTOBER 31, 1997
Rental revenue. Rental revenue was approximately $108,655,000 and
$56,964,000, or 87.7% and 89.1% of total revenues for the six months ended
October 31, 1998 and 1997, respectively. The increase in rental revenue of
$51,691,000 was derived primarily from the 266 video stores acquired from
Moovies in March 1998, from the opening of 14 Company-owned stores, net of
closings, since the second quarter of fiscal 1998, and from a 2% increase in
same store revenues. Rental revenues did not meet management's expectations for
the quarter, primarily due to the continuing conversion of the Moovies locations
in several significant markets as well as the simultaneous impact of revenue
sharing arrangements and copy title depth obtained by competitors in markets
where the Company's stores are located. Management expects that future results
will be positively impacted by the operation of all of the now fully converted
Moovies locations. In addition, the Company is obtaining additional
videocassette product under four direct revenue sharing arrangements with motion
picture studios, allowing it to better compete with larger competitors at a time
when all of its Company-owned locations are now operating under the Video Update
name and operating system.
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Service fees. Service fees were approximately $541,000 and $343,000, or
0.4% and 0.5% of total revenues for the six months ended October 31, 1998 and
1997, respectively. Continuing service fees and royalties from franchisees
accounted for 88.6% and 91.3% of total service fees, respectively.
Product sales. Product sales were approximately $14,681,000 and $6,630,000,
or 11.9% and 10.4% of total revenues for the six months ended October 31, 1998
and 1997, respectively. The increase in product sales of $8,051,000 was
primarily a result of product sales by the Moovies video stores acquired in
March 1998, from the opening of 14 Company-owned video stores, net of closings,
since the second quarter of fiscal 1998 and from the sale of videocassettes of
the movie "Titanic". The increase as a percentage of total revenues was
primarily due to a difference in product mix and high Titanic video sales.
Store operating expenses. Store operating expenses were approximately
$113,065,000 and $53,372,000, or 91.3% and 83.5% of total revenues for the six
months ended October 31, 1998 and 1997, respectively. The increase in store
operating expenses of $59,693,000 was primarily the result of the Moovies video
stores acquired in March 1998 and the opening of 14 Company-owned video stores,
net of closings, since the second quarter of fiscal 1998. The increase in store
operating expenses as a percentage of total revenues was primarily due to: (i)
the impact of revenue sharing arrangements and copy title depth obtained by
competitors in the markets where the Company's stores were located; (ii)
revenues of the acquired Moovies stores lagging behind the Video Update stores;
and, (iii) corresponding higher costs of new video stores prior to revenue
reaching maturity during the first two years of operations. Store operating
expenses consist of the following:
<TABLE>
<CAPTION>
Six Months Ended
October 31, Percent of Revenue
------------------- ------------------
1997 1998 1997 1998
------- -------- ----- -----
<S> <C> <C> <C> <C>
Cost of rental revenue $15,378 $ 37,239 24.1% 30.1%
Occupancy expenses 17,457 36,145 27.3% 29.2%
Compensation and related benefits 14,816 28,627 23.2% 23.1%
Furniture, fixtures, and equipment expenses 2,477 5,043 3.9% 4.1%
Other store operating expenses 3,244 6,011 5.0% 4.8%
======= ======== ===== =====
Total Store Operating Expenses $53,372 $113,065 83.5% 91.3%
======= ======== ===== =====
</TABLE>
Cost of rental revenue was approximately $37,239,000 and $15,378,000, or
30.1% and 24.1% of total revenues for the six months ended October 31, 1998 and
1997, respectively. Cost of rental revenue reflects the amortization of
videocassettes and video games, revenue sharing expenses, and fees paid to
videocassette and video game suppliers. The increase of $21,861,000 was
primarily attributable to the addition of new release videocassette inventory
for new, existing, and the acquired Moovies stores. Cost of rental revenue as a
percentage of revenues for future periods may vary based on the Company's
purchase of videocassette inventory, which is subject to change based on the
Company's rate of expansion, revenue sharing arrangements, studio release
schedules and anticipated market demand.
Occupancy expenses were approximately $36,145,000 and $17,457,000, or 29.2%
and 27.3% of total revenues for the six months ended October 31, 1998 and 1997,
respectively. The increase of approximately $18,688,000 was primarily due to the
Moovies video stores acquired in March 1998 and from the opening of 14
Company-owned stores, net of closings, since the second quarter of fiscal 1998.
Compensation and related benefits were approximately $28,627,000 and
$14,816,000, or 23.1% and 23.2% of total revenues for the six months ended
October 31, 1998 and 1997, respectively. The increase of approximately
$13,811,000 was primarily due to the Moovies video stores acquired in March 1998
and from the opening of 14 Company-owned video stores, net of closings, since
the second quarter of fiscal 1998.
Selling, general and administrative. Selling, general and administrative
expenses were approximately $11,107,000 and $5,623,000, or 8.9% and 8.8% of
total revenues for the six months ended October 31, 1998 and 1997, respectively.
The increase of approximately $5,484,000 was primarily due to (i) additional
personnel and related expenses to support the Company's growth; (ii) outside
legal and accounting fees; (iii) upgraded computer
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and phone systems; and, (iv) bank fees related to the loan facility and
additional stores. The Company anticipates that the expense as a percentage of
revenues will decline in the next year as the Moovies locations are integrated
into its operations.
Cost of product sales. Cost of product sales was approximately $10,099,000
and $3,852,000, or 8.1% and 6.0% of total revenues for the six months ended
October 31, 1998 and 1997. The cost of product sales as a percentage of total
product sales revenue was approximately 68.8% and 58.1% for fiscal 1998 and
1997, respectively. The increase in the cost of product sales as a percentage of
product sales was primarily due to the sale of the Titanic video which was sold
at a low margin due to industry competition.
Amortization of intangibles. Amortization of intangibles was approximately
$2,907,000 and $1,240,000 for the six months ended October 31, 1998 and 1997,
respectively. The increase was primarily attributable to the acquisition of
Moovies in March 1998.
Interest expense. Interest expense was approximately $5,987,000 and
$1,176,000, or 4.8% and 1.9% of total revenues for the six months ended October
31, 1998 and 1997, respectively. The increase of $4,811,000 was primarily
attributable to interest on increased borrowings under the Company's Senior
Facility (as defined below).
Other income. Other income was approximately $181,000 and $180,000 for the
six months ended October 31, 1998 and 1997, respectively.
LIQUIDITY AND CAPITAL RESOURCES
The Company has funded its operations to date through cash from operations,
the proceeds of prior equity and debt offerings, borrowings under bank
facilities, trade credit and equipment leases. The Company's principal capital
requirements are for the opening and build out of new superstores and the
purchase of videocassette rental inventory, each of which varies based on market
conditions, expansion plans and conversion of the acquired Moovies stores.
At October 31, 1998, the Company had cash or cash equivalents of
approximately $830,000. The Company uses an unclassified balance sheet in its
financial statements, and as a result, does not classify its assets or
liabilities as current or noncurrent. If the Company were to use a classified
balance sheet, a portion of videocassette rental inventories would be classified
as noncurrent because they are not assets that are reasonably expected to be
completely realized in cash or sold in one year. The acquisition cost of these
inventories, however, would be reflected in current liabilities. The Company
believes that classification of videocassette rental inventories as noncurrent
assets would be misleading because it would not indicate the level of assets
expected to be converted into cash in the next year as a result of rentals or
sales of these videocassettes.
For the six months ended October 31, 1998 net cash provided by operating
activities was approximately $33,251,000. Net cash used in investment activities
was approximately $43,957,000 consisting primarily of approximately $8,035,000
for new and remodeled stores, and conversion costs associated with acquired
stores, and approximately $35,753,000 for the purchase of videocassette
inventory for existing and new stores. Net cash generated from financing
activities was approximately $10,103,000 resulting primarily from proceeds under
the Company's Senior Facility (as defined below).
In March 1998 the Company completed the acquisition of Moovies, Inc. The
Company issued approximately 9.3 million shares of Class A Common Stock in
exchange for Moovies common stock. The transaction was treated as a tax-free
exchange for federal income tax purposes and recorded under the purchase method
of accounting.
Simultaneous with the closing of the Moovies transaction, the Company
announced that a syndicate led by Banque Paribas had extended it a $120 million
credit/term loan facility (the "Senior Facility") which was subsequently amended
during the second quarter of fiscal 1999. This Senior Facility replaced the
Company's previous line of credit. The amended Senior Facility consists of the
following: (i) two term loans totaling $95.0 million; (ii) a $15.0 million
capital expenditure line; and, (iii) a $5.0 million revolving line, reduced from
$10.0 million. The Company borrowed the $95.0 million of the two term loans in
conjunction with the closing of the
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Moovies merger and the proceeds were used to: (i) refinance approximately
$35,000,000 of outstanding indebtedness including accrued interest under the
Company's previous line of credit; (ii) refinance approximately $50,000,000 of
indebtedness of Moovies under Moovies' previous credit agreement; and, (iii) pay
transaction fees and expenses relating to the Moovies merger of approximately
$10,000,000, (including legal fees, accounting fees, and registration fees). The
capital expenditure line is available to fund the conversion of the acquired
Moovies stores and integration costs, the opening of new stores, working capital
needs, and selected acquisitions. As of October 31, 1998, the Company had $15.0
million outstanding under this facility. The revolving line is available for
normal working capital needs. As of October 31, 1998 the Company had $5.0
million outstanding under this facility.
Amounts borrowed under the Senior Facility bear interest at variable rates
based on the "base rate" (i.e. the higher of the federal funds rate, plus 1/2 of
1% or the prime commercial lending rate) or the interbank Eurodollar rate
(approximately 8.0% and 5.24% per annum, respectively as of October 31, 1998)
plus an applicable margin rate that could range from .5% to 3.75%. Amounts
outstanding at October 31, 1998 had a weighted average rate of 9.45%.
The Senior Facility includes negative, affirmative and financial covenants
including, but not limited to, minimum pretax earnings, minimum free cash flow,
minimum net worth, maximum indebtedness, maximum leverage, minimum fixed charge
coverage, minimum revenue, a prohibition or restriction on capital expenditures,
debt and guarantees, liens and encumbrances on any property, mergers,
consolidations, investments, advances, divestitures, change or business or
conduct of business, joint ventures, partnerships, the creation of new
subsidiaries, dividends, distributions, repurchases or redemptions of
outstanding stock (including options or warrants), the voluntary prepayment,
repurchase redemption or defeasance of debt, and the acquisition, sale or
transfer, lease or sale-leaseback of assets. The Senior Facility is secured by
substantially all of the Company's assets as well as by pledges of its stock in
its subsidiaries, which subsidiaries also have provided guarantees of the
Company's obligations.
As a result of its expected results for the first quarter of fiscal 1999,
the Company sought and obtained certain waivers under the Senior Facility for
the quarter ended July 31, 1998. During the second quarter of fiscal 1999, the
Company and the bank syndicate amended the terms of the Senior Facility to,
among other things: (i) reduced the Senior Facility from $120 million to $115
million; (ii) revise certain financial covenants; (iii) modify the terms of the
capital expenditure line to allow usage for working capital needs; (iv) increase
the overall interest rate by .5%; and, (v) reprice warrants held by the bank
syndicate to a more current market price. As a result of its operations for the
second quarter of fiscal 1999, the Company expects that it will not be in
compliance with certain financial covenants under the Senior Facility. The
Company is in the process of obtaining a waiver for such non-compliance and
based on discussions with lenders, it expects to obtain the waiver
expeditiously. No assurances can be given that future waivers or amendments will
be obtained if the Company is unable to maintain a level of operations necessary
to meet the covenants and requirements of the Senior Facility. If the Company is
unable to maintain such a level of operations, it will be required to reduce its
overall expenditures and expansion plans to comply with the covenants and
requirements of the Senior Facility. Additionally, any failure by the Company to
maintain its level of operations within the covenants and requirements of the
Senior Facility could cause the Company to be in default thereunder, allowing
the lenders to take legal action against the Company, including but not limited
to, the immediate acceleration of payment of borrowed funds, which could
materially and adversely affect the Company's operations. The immediate
acceleration of debt thereunder or the lack of further borrowing capacity, in
whole or in part, would have a material adverse effect on the Company's
operations and financial condition.
In November 1998, the Company entered into a sale/leaseback arrangement
with respect to certain of its furniture, fixtures, equipment and signage used
in selected retail locations. Under the arrangement the Company obtained
approximately $5.0 million.
During the remainder of fiscal 1999, the Company expects to continue its
focus on maximizing the operating efficiencies of its existing and previously
acquired locations and on completing the build out of new stores in locations
for which the Company has signed lease commitments, rather than on aggressively
expanding with new superstores in additional metropolitan areas where it does
not presently have locations. The Company has maintained a longstanding and
satisfactory relationship with its primary product vendors and has negotiated
extended payment terms with several of these vendors. The loss of its primary
product vendors could have a
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<PAGE>
material adverse effect on the Company. In addition to such traditional product
purchase relationships, the Company also recently entered into four direct
revenue sharing arrangements with major motion picture studios, which agreements
allow the Company to obtain videocassette rental product directly from the
studios under arrangements that involve a sharing of revenues over the first
months of the release of a movie title on videocassette. The Company expects
that such arrangements will allow its locations to offer a greater number of
titles and copies of new releases than it would have obtained under traditional
inventory purchasing arrangements, allowing it to compete better with larger
competitors as well as independently owned locations. Given that the Company has
recently entered into such revenue sharing arrangements, no assurances can be
given as to the impact on the Company's operations or that such arrangements
will allow the Company to achieve its intended results.
Assuming the Company is able to maintain a satisfactory relationship with
its selected vendors and its bank lenders, the Company expects that cash from
operations, trade credits, equipment leases, available revenue sharing
arrangements, and available borrowing under the Senior Facility will be
sufficient to fund future inventory purchases and other working capital needs
for the next twelve months, although no assurances can be given that the Company
will not require additional sources of financing as a result of store openings
or build outs currently in progress, disappointing operating results,
unavailability under the Senior Facility as a result of disappointing operating
results, or unanticipated cash needs or opportunities. Moreover, no assurances
can be given that such additional funds will be available on satisfactory terms,
if at all. If the Company is unable to obtain such additional financing, the
Company may be required to reduce its overall expenditures and the Company's
ability to maintain or expand its current level of operations could be
materially and adversely affected.
Daniel A. Potter, the Company's Chief Executive Officer and John Bedard,
the Company's President, have issued notes to the Company (the "Recourse Notes")
in connection with stock option exercises, for approximately $2,080,147 and
$1,155,637, respectively, including accrued interest through April 30, 1998. The
Recourse Notes were issued by the executives upon their exercise in August 1995
of 420,000 options granted to them under the Stock Option Plans in May 1995 at
an exercise price of $4.3125, the fair market value of the stock on the date the
options were granted. The Recourse Notes represent the total exercise price of
such options plus amounts advanced by the Company to such executives to satisfy
then anticipated tax liabilities. The Recourse Notes, which provide for full
recourse against the respective officer's personal assets and Company
stockholdings, are evidenced by promissory notes bearing accrued interest at a
rate of 8% per annum (through April 30, 1998) with payment of principal and
interest due on October 4, 1999. In the event that the obligors sell shares of
the Company's stock, the net proceeds thereof will be applied to payment, in
part or in full, of the Recourse Notes.
In connection with restated employment agreements for Mr. Potter and Mr.
Bedard, the Board has approved an accrual of bonuses that will be directed
primarily to satisfying obligations arising from the Recourse Notes. For fiscal
year 1998, bonus payments aggregating $816,580 were awarded as reimbursement of
previous payments of principal and interest on the recourse notes and
accompanying tax liability to the recipients. In addition, the Board has
approved the subsequent payment of additional aggregate bonuses of approximately
$6,345,000 to be used primarily to satisfy the Recourse Notes as well as the
anticipated income tax liabilities to these executives, subject to any required
approval of the Company's bank lenders. If such bonuses are not effected, the
Recourse Notes will remain outstanding.
Reference to Private Securities Litigation Reform Act: Statements made by
the Company that are not historical facts are forward looking statements that
involve risks and uncertainties. Actual results could differ materially from
those expressed or implied in forward looking statements. All such forward
looking statements are subject to the safe harbor created by the Private
Securities Litigation Reform Act of 1995. Important factors that could cause
financial performance to differ materially from past results and from those
expressed or implied in this document include, without limitation, the risks of
acquisition of businesses (including limited knowledge of the businesses
acquired and misrepresentations by sellers), including the acquisition of
Moovies, changes in business strategy or development plans, new store openings,
availability of products, availability of financing, competition, management,
ability to manage growth, loss of customers, weather (particularly on weekends
and holidays), consumer acceptance of new release videocassette titles, and a
variety of other factors. Further information on these and other risks is
included in the Company's Annual Report on Form 10-K for the year ended April
30, 1998.
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<PAGE>
YEAR 2000 COMPLIANCE
The year 2000 issue is the result of computer programs that were written
using two digits rather than four to define the applicable year. For example,
computer programs that have time-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. To the extent that the
Company's (and its vendors' and suppliers') software applications contain source
code that is unable to interpret appropriately the upcoming calendar year 2000
and beyond, some level of modification or replacement of such applications will
be necessary to avoid system failures and the temporary inability to process
transactions or engage in other normal business activities.
The Company's information services group has been coordinating the
Company's internal year 2000 compliance efforts and has identified all
computer-based systems and applications (including embedded systems) the Company
uses in its operations that might not be year 2000 compliant. The Company is
determining what modifications or replacements will be necessary to achieve
compliance; implementing any necessary modifications and replacements;
conducting tests necessary to verify that the modified systems are operational;
and transitioning the compliant systems into the regular operations of the
Company. The Company estimates that these actions with respect to systems that
it believes would have a material effect on the business are approximately 60%
complete. The Company estimates that all critical systems and applications will
be year 2000 compliant by June 1999.
The Company is also examining its relationship with certain key outside
vendors, suppliers, and others with whom the Company has significant business
relationships to determine, to the extent practical, the degree of such outside
parties' year 2000 compliance. The Company has been contacting such outside
parties and attempting to seek assurances that such parties will be year 2000
compliant. The Company does not believe that its relationships with any single
third party is material to the Company's operations and, therefore, does not
believe that the failure of any single third party to be year 2000 compliant
would have a material adverse effect on the Company. The Company believes that
if it, or any third party with whom the Company has a significant business
relationship, has a year 2000 related systems failure, the most significant
impact would likely be the inability, with respect to a store or group of
stores, to conduct operations due to a power failure, to deliver inventory in a
timely fashion, to receive certain products from vendors or to process
electronically customer sales at the store level. The Company does not
anticipate that any such impact would be material to the Company's liquidity or
results of operations.
The Company is establishing and implementing a contingency plan to provide
for viable alternatives to ensure that the Company's core business operations
are able to continue in the event of a year 2000 related systems failure. The
Company expects to have a comprehensive contingency plan established by October
1999. If the Company's systems are not sufficiently year 2000 compliant by the
end of calendar year 1999 or if the Company does not have an appropriate
contingency plan in place at that time, the Company's business, financial
condition and results of operations may be materially and adversely affected.
Such adverse effects may include, but may not be limited to, the ability to
manage store operations, collect revenues from customers, supply stores with
inventory, make payments to vendors and suppliers, remit wages to employees, and
conduct other essential business-related activities.
Through October 31, 1998, the Company has expended approximately $200,000
to address year 2000 compliance issues. The Company estimates that it will incur
an additional $800,000 for a total of approximately $1,000,000 to address year
2000 compliance issues, which includes the estimated costs of all modifications,
testing and consultant fees.
INFLATION
To date, inflation has not had a material effect on the Company's business.
The Company anticipates that its business will be affected by general economic
trends. Although the Company has not operated during a period of high inflation,
it believes that it would generally be able to pass increased costs resulting
from inflation on to customers.
13 of 15
<PAGE>
SEASONALITY AND QUARTERLY FLUCTUATIONS
The video rental industry generally experiences revenue declines in April
and May, due in part to the change to Daylight Savings Time and to improved
weather, and in September and October, due in part to school openings and the
introduction of new network and cable television programs.
The Company's video rental business may be affected by other factors,
including acquisitions by the Company of existing video stores, additional and
existing competition, marketing programs, weather, special or unusual events,
variations in the number of superstore openings, and other factors that may
affect retailers in general.
The Company depends significantly on availability and consumer acceptance
of new release videocassette titles available for rental. To the extent that
available new release titles fail to stimulate consumer interest and retail
traffic, operating results could be materially adversely affected.
PART II - OTHER INFORMATION
- ---------------------------
ITEM 1. LEGAL PROCEEDINGS
In connection with the acquisition of the assets of Videoland, Inc.
("Videoland") in November 1995, the Company issued 239,163 shares of its Class A
Common Stock (the "Videoland Shares") to the sellers of the assets of Videoland
(the "Videoland Sellers"). With respect to the Videoland Shares, the Company
agreed to make a deficiency payment in October 1996 to the Videoland Sellers if
the gross proceeds received by such sellers from the sale of the Videoland
Shares during the six months from March 1996 through September 1996 is not equal
to the number of shares of Videoland Shares sold multiplied by $12.00. The
Videoland Sellers were subject to certain "lockup" or sale restrictions as a
condition to any deficiency payment. The Company initiated an action in federal
district court in Minnesota for a declaratory judgment that the Videoland
Sellers are not entitled to any deficiency payment. In January, 1998, the court
entered a judgment against Video Update in the amount of $1,220,000 plus
interest from October, 1996, and attorney's fees. Video Update is appealing the
matter. Although no assurances can be given as to the outcome of such action,
the Company intends to vigorously pursue the matter.
In May, 1998, Rousnam Video, Inc., a Michigan corporation and Hani (Al)
Monsour (collectively "Monsour") filed a lawsuit in state court (Macomb County
Michigan) claiming amounts due pursuant to post-closing adjustments contemplated
in connection with an Asset Purchase Agreement among Monsour and Moovies, Inc.
dated as of March 14, 1997, and the alleged default on a Promissory Note among
Monsour and Moovies, Inc. in the amount of $2,000,000 which is currently
reflected in notes payable. The trial court has ruled in favor of the plaintiffs
on a motion for summary judgment, and a judgment for approximately $2,200,000 is
expected to be entered against the Company in the near future. The Company
intends to appeal the matter, and no assurances can be given as to the outcome
of such action.
In May, 1998, four stockholders filed suit in the US District Court for the
Central District of California. The Plaintiff stockholders allege that Mr.
Potter and the Company made false and misleading statements or omitted material
information about the Company and the video industry during the period April,
1995 to September, 1996, the date of its subsequent public offering. Plaintiffs
are seeking "at least the sum of $967,967," plus interest, additional damages
and attorneys' fees. The Company and Mr. Potter believe that the claims are
unsubstantiated, without merit and they intend to defend the matter vigorously.
A motion to dismiss the First Amended Complaint was granted, but the court
allowed Plaintiffs to re-file. At present, the Second Amended Complaint has been
filed. The Company plans on filing a renewed motion to dismiss.
In August, 1998, the Company filed suit in federal court in Oregon against
Rentrak corporation, an Oregon Corporation. The Company alleges that Rentrak has
violated the federal antitrust law, given Rentrak's position in the market and
its exercise of monopoly power. Various preliminary motions are pending and the
parties have not yet entered into discovery in the matter.
14 of 15
<PAGE>
In addition to the above, the Company is involved in various legal
proceedings arising during the normal course of conducting business. Management
believes that the resolution of these proceedings will not have any material
adverse impact on the Company's financial statements.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
A. Exhibits. The following exhibits are filed herewith:
Exhibit No. Title
----------- -----
27 Financial Data Schedule
B. Reports on Form 8-K. None
--------------------
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
VIDEO UPDATE, INC.
Date: December 15, 1998: By: /s/ Daniel A. Potter
-----------------------------
Daniel A. Potter,
Chief Executive Officer and
Chairman of the Board of Directors
Date: December 15, 1998: By: /s/ Dale E. Lauwagie
-----------------------------
Dale E. Lauwagie
Chief Financial Officer
15 of 15
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED FINANCIAL STATEMENTS FOR THE SIX MONTHS ENDED OCTOBER 31, 1998 AND
IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> JAN-31-1999
<PERIOD-START> MAY-01-1998
<PERIOD-END> OCT-31-1998
<CASH> 830
<SECURITIES> 0
<RECEIVABLES> 4,398
<ALLOWANCES> 0
<INVENTORY> 110,257
<CURRENT-ASSETS> 0<F1>
<PP&E> 88,582
<DEPRECIATION> 17,372
<TOTAL-ASSETS> 279,334
<CURRENT-LIABILITIES> 80,967<F1>
<BONDS> 0
0
0
<COMMON> 293
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 279,334
<SALES> 14,681
<TOTAL-REVENUES> 123,877
<CGS> 10,099
<TOTAL-COSTS> 137,178
<OTHER-EXPENSES> (181)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 5,987
<INCOME-PRETAX> (19,107)
<INCOME-TAX> 0
<INCOME-CONTINUING> (19,107)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (19,107)
<EPS-PRIMARY> (0.65)
<EPS-DILUTED> (0.65)
<FN>
<F1>THE COMPANY UTILIZES AN UNCLASSIFIED BALANCE SHEET PRESENTATION. THIS FORMAT
WAS FOLLOWED BASED ON THE PREMISE THAT THE VIDEOCASSETTE RENTAL INVENTORY
REPRESENTS ASSETS USED BY THE COMPANY TO GENERATE CURRENT OPERATING INCOME, AND
MANAGEMENT BELIEVES THAT TO CLASSIFY ALL OF THESE COSTS NONCURRENT WOULD BE
MISLEADING TO THE READERS OF THE FINANCIAL STATEMENTS BECAUSE IT WOULD NOT
INDICATE THE LEVEL OF ASSETS EXPECTED TO BE CONVERTED INTO CASH IN THE NEXT
YEAR AS A RESULT OF THE RENTALS OF VIDEOCASSETTES.
</FN>
</TABLE>
